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March 18, 2013

An Overlooked Way of Using the Tax Code for Social Policy

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Over time, the U.S. government has created tax policy to encourage what is deemed desired behavior among taxpayers. For example, the mortgage interest deduction helps Americans afford homes. But there are other "social" tax policies that are less obvious. In this post, we'll discuss one of these, depreciation.

Depreciation is a great tax incentive for investors that helps create a supply of rental property. In essence, it encourages investors to buy property for investment and charge rent to those who cannot afford to buy or who chose not to buy a home of their own. Depreciation is a significant tax benefit, but only if the following requirements are met:

The taxpayer must own the property. Taxpayers may also depreciate any capital improvements for property the taxpayer leases.

A taxpayer must use the property in business or in an income-producing activity. If a taxpayer uses a property for business and for personal purposes, the taxpayer can deduct depreciation based only on the business use of that property.

The property must have a determinable useful life of more than one year.

A large portion of the real estate market consists of individuals and families who buy homes in which to live. But the rental market is also very significant. As previously mentioned, the government encourages investors to buy rental property through the depreciation allowance. If you invest in residential rental property, you must depreciate it over a 27.5-year period. Commercial rental property is depreciated over a 39-year period. During this depreciation period, the property owner is allowed a tax deduction for a portion of the property's value which appears as a line item on Schedule E of his tax return. This is essentially another expense which reduces the amount of rental income that flows through to the taxpayer's 1040. It's common that, when taxpayers subtract their expenses (which includes depreciation) from gross rental income, the end result is a net rental income close to zero. In other words, very little tax is due on the rental income.

Without this deduction, investors would be less motivated to purchase rental property and those who rent could find it more difficult to locate suitable housing due to the decrease in supply. This would likely drive rents higher and could result in a rise in homelessness.

Summary

Just as in business, government uses the dollar to encourage desired behavior. Even though we are in a time of record deficits and debt, I'm confident the government will not eliminate the mortgage interest deduction or depreciation allowance for residential rental property. If these actions were taken, the housing market would weaken, prices would fall and rental inventory would decline. This would cause rental prices to rise. In short, if the housing market weakened, the economic fallout could be severe. Hence, the government will look for other ways to generate revenue. Be sure to look under the surface the next time you hear a politician espouse a particular view. I believe the most important question we can ask is, "Why?"